Debt mutual funds have taken a leaf out of cricket. During a match, a batsman when hurt can request for a runner, thereby protecting the injured leg but ensuring they take the strike when the ball is bowled. This simple measure guarantees that the batsman can still score runs by hitting shots, but the injured body part, usually the leg, is protected from the strain of running. When the pain subsides and the batsman can run on his own, the runner goes back to the dressing room.

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Last week, markets regulator Securities and Exchange Board of India (Sebi) decided to formalise the practice of 'side-pocketing' in fixed-income/debt funds based on credit events.

Like in the cricket match, debt funds when faced with a big doubt over repayment of a certain debt security/bond, can have two portfolios temporarily and continue to operate the fund as smoothly as possible. This arrests the ill-effects of such a security on the entire portfolio, while allowing the fund to again add that security when things get back to normal. DNA Money spoke to experts in the MF industry to understand what are the pros and cons for investors from side pocketing.

Credit events galore

Debt MFs have, over the last few years, seen a rise in situations where fixed income fund managers have put money in companies that have faced terrible repayment issues. The IL&FS defaults are fresh in our minds, but major cases of credit stress and or downgrades have been seen in firms like Amtek Auto, Jindal Steel & Power (JSPL), Ballarpur Industries, Deccan Chronicle, Reliance Communications, Jana Small Finance Bank, Religare Group and Sintex Group, among others.

During such situations, some large investors have taken out money first, thus pushing fund houses to sell good debt securities and further reducing the prospect for the continuing fund investor who was already reeling under losses stemming from write-downs.

Yes, in the absence of side-pocketing, some investors could and did get a disproportionate share of the fund's real value by exiting earlier. Those who stayed back were unfairly hurt even more. With side-pocketing, this problem is partly addressed. This is because the bad part of the portfolio is frozen for everyone and only the good part of the portfolio is available to all investors for redemption.

"In the absence of such rules, the illiquid and below investment grade assets continue to remain in the portfolio, thus, the fund manager is forced to sell the good assets to meet redemption pressures. This panic selling can have a detrimental impact on the credit market, just as we saw a couple of months back, when IL&FS group securities were downgraded. Under side-pocketing, when the good and bad assets are split, the investor can still redeem the good portion of his assets at fair valuations. The investor may not be able to sell the bad units until a settlement is reached with the issuer," says Jason Monteiro, AVP - Mutual Fund Research & Content Prabhudas Lilladher.

With side-pocketing in place, the investor may not resort to panic selling as a significant portion of his/her assets will remain unaffected. The fund manager too, will not be unnecessarily forced to sell good assets to meet liquidity requirements. Typically, credit events affect 5-10% of portfolios at the most. So, effectively there would be two portfolios - one having 90-95% of the original investments and the second one would have the affected security/bond.

Meanwhile, experts agree that credit assessment capabilities of debt funds needs to improve. "Faulty credit assessment by fund houses is one of the major causes responsible for debt schemes getting stuck with securities. It's high time that fund houses learn to allocate finances to organisations judiciously, after valuing all their assets, liabilities, investments and expenses accurately," points out Rachit Chawla, CEO, Finway.

Challenges ahead

The most valuable feature in side-pocketing is that it gives the investor an option to take an informed decision. "It's progressive but the downside for Indian MF investors, especially retail investors, is that they don't understand side-pocketing. Hence, retail investors are most likely to find it confusing than progressive," says Ishan Bansal, co-founder, Groww, an online mutual fund investing platform.

The splitting of the scheme, with two different Net Asset Values, can create confusion. "Additionally, there needs to be more clarity on the tax treatment of such a unique arrangement. The investor should not be at the losing end," says Monteiro.

Sebi is expected to come out with operational guidelines soon on this and may come out with some sharp clarifications.

There are definite advantages for both investors and AMCs from side-pocketing. Naveen Kukreja, CEO & co-founder, Paisabazaar.com says: "By allowing the separation and freezing of illiquid instruments from the rest of the fund portfolio, side-pocketing will ensure liquidity for existing investors, while stopping fresh investors from making a windfall after the resolution of the credit event. The segregation and freezing of illiquid instruments will also help fund houses in managing redemption pressures during the credit event."

But would side-pocketing as a fail-safe measure indirectly give fund managers a licence to go for risky bets? Most experts don't think so. The consensus is that side-pocketing will not act as an incentive for recklessness. Credit events that impact MF portfolios leave investors with an unpleasant experience and this is not something any fund house would want.

Investors' interest will be Sebi's first priority when it announces the norms on side-pocketing. The regulator is expected to ensure that this option is not recklessly used by fund managers through stringent guidelines, and is expected to make MFs more accountable for their actions.

Communication could be a double-edged sword. "Whenever a fund manager is doing side-pocketing, they need to inform the investor. And such communication will reduce the trust of the investor in that fund. Hence, just the communication requirement may be a big deterrent for fund managers to misuse it. The regulation should include a proactive communication across all channels to the investor whenever side pocketing is contemplated," argues Bansal.

DIVIDE AND RULE

  • Debt funds, when in doubt over repayment of a security/bond, can have two portfolios temporarily and operate the fund. This arrests the ill-effects of such a security on the entire portfolio  
  • The bad part of the portfolio is frozen for everyone and only the good part of the portfolio is available to all investors for redemption  
  • This will ensure liquidity for existing investors, while stopping fresh investors from making a windfall after the resolution of the credit event